Consider the information in the Loanable Funds Graph and assume that the expected rate of inflation is 2%. The demand for loanable funds in the graph consists of the demand by households and firms. Currently, the government is not borrowing any money, because its tax revenue is sufficient to finance its expenditures. Therefore, the equilibrium nominal interest rate equals percent.
Now a war breaks out and to finance the purchase of additional military equipment the government has to borrow in the loanable funds market. So it comes to the loanable funds market and borrows $1,600 to finance the war effort. The government's borrowing decision is not affected by the real interest rate. So demand for loanable funds increases by $1,600 at every value of the real interest rate.
At the same time, as the government purchases the new military equipment, people expect the inflation rate to increase to 5%.
The new equilibrium nominal interest rate will then be percent.